To prove this adage, see Daniel D. and Dorothy Hultquist v. Com’r, 2011 T.C. Mem. 17, 1/24/11. Daniel D. gave money to one Duncan to develop fishing tackle, without any documentation. Daniel D. testified at trial he hoped to recoup the $32,000-plus he gave Duncan out of profits on the sales of the tackle.

Their venture never proved profitable, and Daniel D. alternatively claimed the $32,000 as cost of goods sold or as a business bad debt.

Without adequate records to substantiate the application of the money Daniel D. gave to Duncan (in simple terms, what Duncan spent the money for), and without a promissory note or any written acknowledgment of a debt from Duncan to Daniel D., Tax Court disallowed any deduction on any ground.

The principles enunciated in this case are nothing new, and in fact permeate most of the cases coming before Tax Court. But every so often, one finds a hidden gem in the dross. Daniel D.’s accountant (apparently a Certified Public Accountant, but in what State is not specified) delivered himself of this pronouncement:

“Petitioner showed the trial balance to his accountant, Wesley L. Delaney (Mr. Delaney), who advised petitioner to include the inventory total in cost of goods sold. Mr. Delaney advised petitioner to do this because ‘[Maiden Ventures is] a cash basis taxpayer, and a cash basis taxpayer is not going to have inventory’.” Huh?

Incidentally, Daniel D. was assessed a late-filing penalty.

The old Chinese adage is true: “The worst scrap of paper is better than best human memory.”

Or maybe not. There haven’t been any interesting Tax Court cases in the last two weeks, barring one innocent spouse decision that was the usual fact-specific cocktail of factors. Such decisions are almost useless, because one’s own client’s case is never identical to another; it’s our old friend The Wilderness of Single Instances.

And I’m not going over the latest Congressional enactment. It’s been blogged to death, as now the idea of a consumption tax to replace the present monstrosity of the Internal Revenue Code is being blogged to death. After all the usual arguments, both valid and invalid, are made, we can trust Congress to act with its accustomed cowardice, making a bad situation worse.

So silence has been golden. One of my readers told me that a blog like this must be constantly refreshed, lest readership grow tired and leave forever.  My answer is that, if a blog is refreshed with fluff and nonsense, readership will grow tired and leave forever even sooner.

Or, put another way, substance matters.

In Part One, A Piece of the Action, I discussed the pitfalls of relying upon the same experts, who sold and promoted the deal, to avoid penalties when the IRS unwinds the deal. Now here is another instance where the experts can hurt the taxpayer–when counsel hasn’t carefully worked with experts, reviewed their reports, and carefully prepared the experts for depositions and trial testimony.

The Court of Claims, in an exhaustive and exhausting review of the expert testimony (three for taxpayer, of whom one was disqualified as testifying on a matter of law, which it was the Court’s function to determine, and one for IRS), focused on the anticipated economic profitability of the foreign currency “collar” transactions, which the Court found to lack economic substance or substantial business purpose for want of reasonable expectation of profitability.

If the Court could find a reasonable expectation of profit without considering the tax impact, the taxpayer wins.

Taxpayer’s experts’ credentials were impressive; their performance, both before and during trial, was much less so.

One of taxpayer’s experts never bothered to calculate the probability of economic profit. The other did, but never figured in the transaction costs (multi-millions in legal fees plus the premium paid to Deutsche Bank, the counterparty to the purchased foreign currency options that comprised the collar). One of taxpayer’s experts failed to run an industry-accepted formula for calculating the expected outcome of the option trades.

IRS’s expert did all of the above, ran all the numbers with all the right formulas, and came to a conclusion that would have warmed Max Bialystok’s heart (cf. The Producers)– the deal had better than a 70% chance of making nothing. In fact, the chances of hitting the “sweet spot” (where the collar paid off big time) were, for all practical purposes, zero. But for an anomaly in the Regulations to Section 752, the deal would be insane, but because the Regulations at that time allowed one-half the deal to count for tax purposes but not the other, taxpayers were taking advantage. The Court bought the IRS’s expert’s testimony 100%.

The takeaway for counsel? As with currency trades, every litigated case has a “sweet spot”, the one disputed point your side must prove to win.  Before choosing experts, ask what you want your experts to establish to hit the “sweet spot”. Work with them. Learn their craft, so far as possible. And sweat them good, both in preparation of their reports and in preparation for depositions. And if they can’t properly opine, it’s time for a major heart-to-heart with the taxpayer-client.

IRS won this case at the report exchange stage, because taxpayer’s experts could not establish the one point needed to win. Incomplete analyses are worthless, and the Stobie Creek taxpayer must have paid plenty for them.

The Court threw taxpayer and those similarly situated a bone by refusing to apply the Treasury’s fix to the Section 752 Regulations retroactively. To the extent the Court devoted an extensive analysis to retroactivity of Treasury Regulations, the Court did all taxpayers a service. It’s worth reading.

For the rest, it’s a cautionary tale to tax advisors. The woodshed is your, and your experts’, best friend. Woodshed your experts, or watch them get shredded on the trial.

Old-time “Star Trek” fans will remember Bela Oxmyx, the outer-space gangster who was looking for a piece of the action. But Circular 230 personnel would be well-advised to forswear a piece of the action, especially after reading Stobie Creek LLC v. US , 82 Fed.Cl. 636 (2008), affd, 608 F.3d 1366 (Fed. Cir. 2010). This Court of Claims decision, affirmed in June, 2010, shows again the perils of tax advisors being compensated with “a piece of the action”.

This case presents yet another variation on the sham foreign currency deal. Taxpayer was an LLC taxed as a partnership. Taxpayer’s partners were selling the family business. As usual, it was a corporation because Daddy made it so. Also as usual, the family’s basis in their shares was pennies and the gain multi-millions. So the family put their stock in a partnership and threw in a foreign currency options deal that would have a 99% chance of yielding nothing economically, but which, after the foreign currency deal yielded the expected zero result, would allow the partners to distribute the partnership assets with a greatly stepped-up basis.

I’m less concerned with the details here, but Judge Christine Cook Odell Miller was willing to wade through the wheeling-and-dealing for 128 pages. If Digital Option Trading is your thing, read them all. For me, there are two takeaways: first, don’t take a piece of the action, and second, woodshed your experts good. For now, I’ll only discuss taking a piece of the action.

Taxpayer’s key advisors were the family lawyers, who had represented Daddy when he first bought the lumberyard that was the cradle of the family fortune, and the ill-fated Dallas-based Jenkens & Gilchrist, P.C., law firm, which later came massively unglued for promoting phony tax shelters.

Leaving aside the want of economic substance that permeated the transaction, and the taxpayer’s blatant tax-avoidance motivation, once the Court found for the IRS’s imposition of tax, taxpayer sought relief from 6662 penalties by claiming good-faith reliance on experts.

Though the Court extensively canvassed the substantial authority and reasonable basis arguments, the Court found that the conflict-of-interest arising out of the manner of compensation of the two parties relied upon by taxpayer, put taxpayer out of court. Both the family lawyers and Jenkens & Gilchrist, P.C., were paid a flat fee based on a percentage of the tax savings their gambit was intended to generate. And the Court stated that the family lawyers who introduced taxpayer to Jenkens & Gilchrist, P.C., were little more than brokers, selling a tax dodge on commission.

Though taxpayer’s controlling person was an ex-Wall Streeter who claimed to be immune to sticker shock from legal fees in big deals, the Court was obviously troubled by anyone relying upon experts who were being paid what amounted to an upfront contingency fee on a tax saving.

The Court never mentions Circular 230 (the current version of which was not in effect when the Stobie Creek deal went down), but the fees provision thereof very much speaks to the point. See Circular 230 §10.27(b). Contingency fees are prohibited except in certain instances–and this case isn’t one of them.

Recall once more Canal Corporation and Subsidiaries v. Commissioner, 135 T.C. 9 (8/5/10), which cites Stobie Creek for the proposition that taxpayers cannot rely on advice furnished by the very persons who are promoting the deal. There the advisor was paid a very large, upfront fee; the advisor had a huge stake in taxpayer’s buying into the deal.

Penalties sustained.

There are certain pressures against which the better angels of our nature often strive in vain: high on that list is the pecuniary interest of the pressured one.

In short, tax professional: don’t do it.

Usually I don’t comment on 7463s, the small claims, no appeal cases. Most of them are time-wasting, no-documentation reiterations of the same theme. But Beverly Bernice Bang,  T.C. Sum. Op. 2011-1 (1/4/11) carries an important message for parties other than the petitioner/taxpayer (Bang).

Bang was an investor in a jojoba “research” deal in 1983. She clearly wasn’t a sophisticated investor, nor was her investment very large. At the end of the day, her actual tax liability when IRS blew up the deal was under $2700. Of course, her accountant never bothered to file a timely petition after she got the 90-day letter, 22 years after she took the deduction that led to the underpayment, but we’ll pass that.

The case comes up on a 6330 levy review. Of course, having had an opportunity to contest the liability and not having timely filed, Bang had no chance to contest the underlying liability which, with interest from 1984 to 2006, plus tax-motivated transaction interest, plus failure-to-pay penalty, amount to more than $32,000. IRS also assessed a $13.18 failure-to-pay-tax penalty.

After granting summary judgment to IRS, the Court reserved judgment on the $13.18 penalty. I cannot imagine there will be a trial on that issue.

The point of this story for professionals is how the interest accrued. IRS issued a Notice of Final Partnership Administrative Adjustment in 1989, six years after the tax year in question. The partnership promptly petitioned Tax Court for review.

However, the tax matters partner, who had authority under the partnership agreement to bind all the partners, large and small, stipulated in 1994 to be bound by the results in a similar Tax Court case  (the similar case) involving an unrelated taxpayer. That case was decided in 1998, and the unrelated taxpayer lost.

For some reason, an Order and Decision in Bang’s partnership’s case, confirming the result of the similar case, was not made or entered until 2005, 22 years after the fact, with interest running all the while at the enhanced tax-motivated transaction rate.

Bang’s deficiency notice was issued in 2006. The Bang Court refused to abate the interest under 6404, because litigation delay was not a ground for abatement.

What was communicated between the tax matters partner and the other partners is not part of the decision. If the other partners had known that interest was running on any underpayment at an enhanced rate, one wonders if they would have stood by for 22 years, while a $2700 liability became a $32,000 liability. One also wonders what the statute of limitations might be to bar a partner from bringing suit against the tax matters partner for breach of fiduciary duty in not warning the partners of the potential interest consequences, and for negligence in waiting seven years to move the partnership’s Tax Court case forward to keep interest from accruing.

Tax matters partners are partners first, and tax matterers second. And given the current bifurcation between partnership-level adjustments and the impact on individual partners, from the latter of whom the effects of these partnership-level adjustments might be hidden for decades, tax matter partners should be aware that although hidden, the impact may be substantial upon those partners—and possibly on the tax matters partners’ wallets.

When Congress enacted certain tax credits, they meant to encourage activities otherwise unprofitable. To raise money for these projects, the promoters essentially sold tax credits in exchange for capital. This the Tax Court countenances, and exalts over many other Code provisions,  most recently in Historic Boardwalk Hall, 136 T.C. 1, released 1/3/11.

To make a very long story short, the New Jersey Sports and Exhibition Authority (NJSEA), a creation of the New Jersey State government, wanted to rehabilitate Boardwalk Hall in Atlantic City, New Jersey, as a sports and exhibition venue. The Hall was already on the National Register of Historic Places, so rehabilitation and restoration expenses would have qualified for the 20% tax credit pursuant to IRC§47.

NJSEA shopped their proposed partnership deal through a professional marketer of tax credits, and Pitney Bowes made the winning bid.

Wading through the extensive documentation that spelled out the deal, IRS tried to prove the deal was a sham, that Pitney Bowes had no substantial stake in the outcome of the rehabilitation or the ongoing operation of the Hall. The underpinning of  IRS’s argument is that absent the tax credit, Pitney Bowes’ participation lacked economic substance, and therefore the mandatory analysis of the net effect to Pitney Bowes’ pocketbook should disregard the effects of the tax credit.

The Tax Court responded that to disregard the effects of the tax credits would be to disregard Congress’ will–to encourage the rehabilitation of historic structures; that Congress knew that the majority of such rehabilitation projects could not succeed without tax incentives; and finally the Tax Court ran roughshod over any conflicting provision of Code or Regulations that IRS could muster.

The Third Circuit will no doubt have something to say about this. Follow.

We heard a great deal about economic substance this year, what with foreign currency swaps (e.g., LR Development Company LLC, Transferee, T.C. Mem. 2010-203, 09/16/10) and the Health Care Reform bill. Mostly it’s the taxpayer who gets nailed on the doctrine. But for once, the Tax Court gives a New Year’s Eve present to a taxpayer, and the economic substance doctrine gets credit for an assist.

In Judith F. Lang, T.C. Mem. 2010-286, 12/30/2010, the taxpayer’s mother, Mrs. Field, paid $24,559 directly to the medical provider for health care for her daughter, the taxpayer. That gift was not subject to gift tax, of course (see IRC§2503(e)(1)), as it was paid by Mrs. Field directly to the provider, Mrs. Field having no obligation to support the taxpayer, as the taxpayer is not a minor.

Generous Mrs. Field also paid $5,508 directly to a local taxing authority for real estate taxes due and owing from taxpayer.

IRS disallowed taxpayer’s deductions for the gifted amounts, claiming form of the transaction governs, and disallows taxpayer’s medical deduction and real estate tax deduction to the extent each was covered by Mrs. Field’s gifts.

Taxpayer’s position is that in substance it was equivalent to Mrs. Field’s writing a check to taxpayer and taxpayer paying the creditors. The Court expressly refuses to allow the gift tax implications to override State law (in this case Massachusetts) that payment to a creditor of the donee, made with donative intent, is a gift to the donee.

The Court stated at pages 4-5 of its decision: “There is precedent for State law controlling whether a gift at the time of payment affects who is the payor. See, e.g., Ruch v. Commissioner, T.C. Memo. 1982-493, revd. on another issue 718 F.2d 719 (5th Cir. 1983). Mrs. Field made the medical expense payments for her daughter with donative intent. Although Mrs. Field and petitioner would not be subject to the gift tax, the income tax treatment in this context is not controlled by the gift tax consequence. See Pierre v. Commissioner, 133 T.C. 24, 35 (2009). Applying substance over form, we treat petitioner as having received from her mother a gift of $24,559 with which petitioner paid her own medical expenses. Petitioner should be credited with having made the payments for purposes of the income tax deduction in question.” [Footnote omitted]

The Court also does not consider gift tax implications of Mrs. Field’s real estate tax payment. The limited class of nontaxable direct payment gifts (IRC§2503(e)(2)(A) and §2503(e)(2)(B)), educational tuition and medical care, does not include real estate taxes. However, the amount paid, $5,508, is below the annual exclusion. Nevertheless, the Court leaves gift taxes as a question for another day.

Neither gift involves a potential double deduction. Mrs. Field did not claim the deduction for the medical expenses, taxpayer did. And the real estate taxes were solely the obligation of the landowner, the taxpayer, and could only be deducted by her.

In short, a clear win for the taxpayer. Substance does trump form.

With year end fast approaching, small businesses can benefit from taking small but meaningful steps to address their tax position before 2011. This list of 23 tips which appeared in the San Francisco Examiner and the micro-business blog Simplicty Mastered gives some great advice to small businesses looking to shore up their tax situation before the New Year.

Best of luck in 2011!

Although it is clearly an extreme example, Griffin v. Comm’r, T.C. Memo. 2010-252 (11/17/10) does highlight several important areas for taxpayers to consider when preparing and filing their U.S. Federal income tax returns.

1. File timely. Late filings will likely receive greater scrutiny and consistently late filings raise a red flag for the IRS. Filing timely will also start the statute of limitations running.
2. Get your ducks in a row. Having correct and complete supporting documentation is critical to substantiating credits and deductions when a taxpayer is under audit.
3. Perception beats Reality every time. Regardless of the veracity of the witness or the documentation, the appearance of impropriety or a story that changes from one telling to the next is a disaster for taxpayers trying to defend themselves. Stick to the truth. Always.